Strategic Risk Management summary

The Holy Grail for investors is a crisis-proof portfolio – one that holds strong in the best and worst of times. Unfortunately, unless you’re clairvoyant, you’re going to be vulnerable to unpredictability. But there are a variety of tools and strategies you can use to safeguard your portfolio during significant stock market downturns. 

Continuously holding short-dated put options is a reliable strategy, but it can be expensive. Another approach is holding “safe haven” treasury bonds, which can generate positive returns but may not perform well during crises. Long positions in gold and credit protection can be moderately reliable and cost-effective.

Investment strategies aren’t the only way to crisis-proof your portfolio. In this section, we’ll discuss how using volatility targeting can give your portfolio some crisis protection. 

The basic idea is to keep your portfolio’s volatility steady at a set target level. You do this by adjusting how much leverage you’re using as volatility changes. There are two key things about volatility that make this work: it tends to persist, and it’s negatively related to stock returns. 

Another way to mitigate risk is by rebalancing your portfolio. 

This is far from a quick fix. In fact, it can result in a portfolio that underperforms. On the flip side, a pure buy-and-hold approach lets your asset mix drift over time, so it loses diversification. That’s why it’s important to find a balance.

You can’t maintain a healthy portfolio without factoring in the human element. Investment management isn’t like riding a bike. You can lose skills. Whether it’s because of abrupt changes in the market or personal factors, you may at some point have to hire, move, or fire a manager to the benefit of your portfolio. 

Making this decision is directly connected to drawdowns, so that’s what we’re going to focus on in this section: strategies for reducing risk when dealing with investment managers.

You now know that managing risk to your portfolio requires investing strategically, employing risk mitigation strategies, and making sure your investment manager is on top of their game. Next, we’re going to explore systematic versus discretionary approaches in hedge funds – and the risks associated with each style. 

Systematic funds employ algorithmic, rules-based strategies. Discretionary funds, on the other hand, rely on human expertise and real-time insights. 

The quantitative strategic risk management framework we’ve outlined in this Blink was put to the test during the COVID-19 pandemic. This period created an out-of-sample stress test as equities experienced a severe drawdown – and proved that these quantitative approaches can effectively function during real-world extremes. 

First, the performance of various investment strategies was assessed. Allocations to trend-following and certain long-short equity strategies focusing on quality and profitability proved effective during the drawdown. These positive convexity approaches lived up to their promise of providing crisis alpha.